Two and Twenty. Private equity fund managers are compensated in two primary ways: management fees and carried interest. The management fee, traditionally two percent annually, is paid to the managers to cover overhead, salaries, and so forth. The carried interest, traditionally twenty percent, is a share of the profits from the underlying investments. My paper Two and Twenty described the typical arrangement. Management fees are taxed at ordinary income rates; carried interest is often taxed at capital gains rates. I focused in the article on why the carried interest portion is better viewed like bonus compensation and should be taxed at ordinary income rates.
Management Fee Conversion. Current law on carried interest is already a sweetheart tax deal for private equity, but why not make it better? Private equity folks are not the type to walk past a twenty-dollar bill lying on the sidewalk. In the 2000s it became common for private equity fund managers to “convert” their management fees into carried interest. There are many variations on the theme, but here’s how many deals worked: each year, before the annual management fee comes due, the fund manager waives the management fee in exchange for a priority allocation of future profits. There is minimal economic risk involved; as long as the fund, at some point, has a profitable quarter, the managers get paid. (If the managers don’t foresee any future profits, they won’t waive the fees, and they will take cash instead.) In exchange for a minimal amount of economic risk, the tax benefit is enormous: the compensation is transformed from ordinary income (taxed at 35%) into capital gain (taxed at 15%). Because the management fees for a large private equity fund can be ten or twenty million per year, the tax dodge can literally save millions in taxes every year.
The problem is that it is not legal. Because the deals vary in their aggressiveness, there is some disagreement among practitioners about when it works and when it doesn’t. But in my opinion, and the opinion of many tax practitioners, the practices that were common in the private equity industry in the 2000s became very, very questionable, and it’s unlikely that they would have stood up in court.
Fund VII. Gawker today posted some Bain documents today showing that Bain, like many other PE firms, had engaged in this practice of converting management fees into capital gain. Unlike carried interest, which is unseemly but perfectly legal, Bain’s management fee conversions are not legal. If challenged in court, Bain would lose. The Bain partners, in my opinion, misreported their income if they reported these converted fees as capital gain instead of ordinary income.
Here’s one example, from Bain Capital Fund VII LP (2009), pp. 13-14 (see here). In any given year, the manager (Bain) can waive its management fees, and allocate the fees instead to a particular investment in the fund. If that investment appreciates in the future, the general partner (Bain) takes a “Priority Profit” off the top. While Bain did not waive its fees for this fund in 2009, it had done so earlier in the life of the fund, to the tune of tens of millions of dollars. (5% of its total holdings of Bombardier Recreational, for example, came from fee conversions — making the fee conversions alone worth about $7 million in 2009).
To be clear, there is some economic risk, and presumably this is how Bain’s tax counsel justified its reporting. The economic risk is that the priority profit must come from future profits, presumably from the investment to which the converted fee is allocated. On the other hand, the managers get to choose which investment in the portfolio they want to skim, and they are in a good position to know which investments are safest. Because the fees come off the top, they are not subject to real investment risk, but only the limited risk that even their best investments will decline in value, every single quarter, for the rest of the life of the fund. Even in 2009, an iffy year for Fund VII, the priority profit share increased in value by $3.8 million.
(UPDATE: Here’s another example. Bain Capital Fund X LP reported that it converted $338 million as of the end of 2009. At a 20% tax rate differential, that $67 million in taxes unpaid. Plus deferral.)
Bottom line: Mitt Romney has not paid all the taxes required under law.
(UPDATE: Yes, Romney left Bain in 1999 or 2002. But as part of his severance agreement, he continues to receive interests in these funds, which he has reported on his financial disclosures. In the usual case, a departing partner would receive an economic stake in the GP (Bain Capital Partners X, LP), rather than an economic stake in the LP (Bain Capital Fund X, LP) — representing a payment for the management services he provided in the past. Indeed, because he filed an 83(b) election, we can be sure that he received GP interests as part of his severance agreement, and that he therefore benefited personally from management fee conversions.
(UPDATE: A couple more points. The Romney camp has complained that because Romney was a “blind investor” in the funds after 2002, it’s unfair to blame him for any tax dodging. They don’t deny that he benefited economically from the fee conversion or the lower taxes that followed. So the question is, can we fairly attribute the tax dodge to Romney?
Romney here is not like a passive mutual fund investor. He helped engineer the funds in the first place. For at least some of the funds, the fee conversion was set in place at the time of the fund’s formation — in the case of Fund VII, when Romney was the sole shareholder of the management company that actually waived the fees (2000). It seems reasonable to infer that fee conversions were in place for earlier vintages of Bain Capital funds as well. I haven’t yet reviewed all of the Gawker documents, but we are talking hundreds of millions of dollars in tax liability on these funds — one hundred million in Fund IX alone (20% of the $500 million converted), another $70 million in fund X. It is unthinkable that in the 1990s through 2002, when Romney was putting together funds, that he was unaware of the fee conversion strategy, or that he was unaware that he continued to benefit from it today.
A note on the economic risk in these deals. The whole tax argument rides on the fact that, in theory, the priority allocation is not guaranteed. If it were as good as cash, then it would be taxed as cash (ordinary income on receipt). So the argument is that if the fund performs badly, the manager might not receive the waived fees. But here’s the thing. It’s hard to imagine a worse financial catastrophe than what we saw in 2008-09. And yet Bain did just fine and received most or all of its fees. The economic risk is entirely ginned up for the benefit of the tax authorities, and it’s not surprising that even in the midst of a financial crisis, the Bain managers got paid their compensation, in full, at capital gains rates. (Remember this is the part of the compensation that’s supposed to be taxed at ordinary income rates.) Now, I’ll check the financials of these funds to see if any of the waived allocations were impaired during the crisis. But from what I looked at today, the economic risk was indeed as ephemeral as it was designed to be.
Finally, I should underscore that fee conversions were really widespread in the PE industry. But that doesn’t make it legal. Audits are private, so I don’t know what, if anything, the IRS has been doing about it. There are no litigated cases that I am aware of, though I haven’t checked in a while. I’ll try to find some time to do that tomorrow; I welcome any assistance from practitioners who are more up to date than I am.)
I talk about management fees on page 23-24 of Two and Twenty (NYU Law Review 2008).
Gregg Polsky (North Carolina) has a terrific paper on the topic: Private Equity Management Fee Conversions (Tax Notes 2009)
Coverage of this story:
Jesse Drucker, Bloomberg